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New laws to restrict a right to terminate a contract for insolvency events

As part of broader reforms to Australia’s corporate insolvency laws, new laws will restrict the ability of a party to enforce a right to terminate a contract in the case where the counterparty suffers an insolvency event (commonly known as ‘ipso facto’ clauses).

What are ‘ipso facto’ clauses?

‘Ipso facto’ clauses are common in all types of commercial contracts. An ipso facto clause generally provides a contractual right for one party to terminate or modify the operation of a contract on the occurrence of a specific event. In the insolvency context, under an ipso facto clause, a party can terminate a contract due to an ‘insolvency event’ such as insolvency, appointment of a managing controller or entering into administration. Currently, such a provision can be enforced regardless of whether the counterparty is continuing to perform its obligations under the contract.

The main benefit of these clauses is that it gives the terminating party freedom to exit a contract as soon insolvency becomes a real risk, rather than waiting until it actually happens by which time it is likely to have suffered actual losses as well as having to deal with a contractual counterparty in financial distress.

What do the new laws do?

On 12 September 2017, the Commonwealth Parliament passed the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) (Act). The Act amends the Corporations Act 2001 (Cth) (Corporations Act) to ‘stay’ a party from exercising its contractual rights on the basis that the counterparty suffers an insolvency event. The new restrictions affect a party’s contractual rights to terminate, modify or suspend the contract, or to call in bank guarantees pursuant to an ipso facto clause.

The purpose of the reforms is to protect companies in financial difficulties that are undergoing genuine restructuring. The refinement to the application of ipso facto clauses during insolvency is hoped to enable a business to continue to trade on in order to recover from an insolvency event. The object of the amendments is to promote a culture of entrepreneurship and innovation, and reduce the stigma associated with business failure, to drive business growth and encourage risk. However, the reform does not cover companies that enter into a DOCA, or companies undertaking an informal restructuring in reliance on the new safe harbour laws.

When do the new laws take effect?

The amendments will come into force on 1 July 2018, unless the Act is proclaimed earlier.

The new laws will not be retrospective, i.e. they will only apply to contracts, agreements or arrangements entered into from the commencement time of the Act.

What these new laws mean for you and what steps should you be taking now?

The new laws cannot be contracted out of. Accordingly, over the next few months, parties negotiating new contracts, or renegotiating existing agreements, should give close consideration to ipso facto clauses in contracts

Parties should assess how they may be impacted by the proposed stay on ipso facto clauses and consider measures that can be taken to minimise the effect of such clauses on the occurrence of an insolvency event

Parties will still maintain the right to terminate or modify contracts for reasons unrelated to the counterparty’s financial position, such as a breach involving non-payment or non-performance

Parties should ensure processes are in place for improved counterparty selection to minimize the risk of an insolvency event occurring during the term of a contract. This may include increased due diligence of the counterparty (i.e. conducting PPSR checks, ASIC searches and inspecting financial records)

Parties may also wish to include a ‘termination for convenience’ clause in contracts for situations where it is possible to identify the counterparty’s financial distress prior to the ‘stay’ taking effect

Parties should consider bolstering rights that are unaffected by these new laws (for e.g. parent company guarantees, rights to inspect current financial statements at any time)

Under the new laws, where it is appropriate in the interests of justice, an affected party can apply to the Federal Court to have a ‘stay’ lifted.

Compare jurisdictions:Restructuring & Insolvency

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